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Friday, July 31, 2009

Housing is actually doing better than I thought it would. We have now seen pretty good increases in new home sales, existing home sales, and even the Case Shiller index posted a month-over-month increase.

There is great debate over exactly how good these numbers are. I'm getting a little sick of the term "less bad is good" but it does neatly summarize where we are. In many ways, it depends on what exactly you are trying to analyze. Or put another way, what question are you trying to answer?

When will the recession end?This is basically a question of GDP growth. The 4Q/1Q inventory liquidation will eventually turn into a rebuilding of inventories, which in turn will eventually result in positive GDP. In simple terms, inventories got so low that any sales activity required greater production activity. It isn't that final sales activity is "normal" or "good" but that the economy was set up for lower final demand than we're getting. Keep this theme in mind as we go.

In terms of housing, the direct impact was classically from home construction. Any kind of positive contribution from construction was long ago lost, so I see this as a minor element.

What about consumer spending?The whole mortgage equity withdrawal game is also dead, and has been for a while. This was once a source of consumer spending, and its a source that isn't likely to come back any time soon.

However, the negative equity story remains. Right now, based on Case Shiller, nationwide home prices are approximately where they were in 2003. Most people who bought their homes in mid-2004 or so, and put 10% down are now underwater. Foreclosures and "jingle mail" catch the media's attention, but the reality is that most of these people who are underwater will just keep paying their bills month after month. Most of those same people can afford the payments, but won't be able to afford to actually move out of the place until they have saved a lot more money. Home price appreciation from here won't be enough. So basically we have people saving more and staying in their homes longer.

Therefore I see an elevated savings rate for many years to come. This will be consistent downward pressure on consumer spending, although it wouldn't prevent consumer spending from increasing from one period to the next. Just that each period will be lower than it otherwise would have been.

Have home prices stabilized?All the current trends say yes. Think back on why home prices started to fall in the first place. There was too much supply and not enough demand. In any good, when there is a supply/demand imbalance we'd expect to see a period of low generalized activity as both suppliers and consumers engage in price discovery. This is exactly what happened in housing, as activity plunged along with prices.

Now we're seeing activity pick up. Both new and existing home sales have increased in 4 of the last 5 months, despite interest rates rising during that period. New home sales have risen a total of 17% since January, while existing home sales are us 9%.

Yes, the absolute level of sales is still anemic. I know. But these are numbers which have historically shown long dragged out trends. I believe that once a positive trend is established, these numbers will keep improving.

Besides, its worth noting that the "normal" level of housing transactions needs rethinking. If people are going to stay in their homes longer, then the velocity of housing transactions should be persistently lower.

Regardless, the uptick in activity suggests that buyers and sellers are coming together on prices. I think the fact that Case Shiller has basically been flat the last two months backs that up. This isn't to say homes might not keep falling in some parts of the country, but the nationwide, generalized decline phase is over.

If housing is to take another turn lower, there will need to be some catalyst. I'd think the most likely would be that the Fed is forced to aggressively hike rates. I think that's a low probability event, but possible nonetheless.

All this being said, I don't have any particular reason to believe home prices will rise rapidly from here. It would seem that we'd need an improvement in employment before housing can advance significantly, at least on a national level.

What about the banking system?That's an uglier picture. Home prices can start rising from here, GDP can rise from here, but banks are saddled with all kinds of legacy problems. Home mortgages, developer loans, commercial loans, etc. Some of it directly related to housing, some not. I've already talked about the residential problem: that negative equity is going to take a long time to work off. Not only does that result in larger losses on each mortgage that must be foreclosed, but it means less turnover among their existing mortgage portfolio. Less fees, less cash flow, its a negative all around.

Commercial real estate is a whole other game. I think a lot of commercial real estate securities might be fairly priced, but commercial real estate loan losses are just beginning.

Now I'm not saying the banks are all going down, but I think there are some larger regionals that are in trouble. And as I said with CIT, a lot of them won't be deemed To Big to Fail. Is KeyCorp too big? Fifth Third? Marshall and Ilsley? I don't think so. In fact, I'm not 100% sure that Wells Fargo doesn't need more capital before this is all said and done.

All this comes in context with how well the securities markets are doing. I personally don't have much at all invested in stocks. I don't understand why they've run as much as they have, but I'm also not here to say it ought to crash from here either. I just don't understand it.

I guess my problem is with how the debate is being framed. Things are getting better in the economy. I don't think that's debatable. The debate should be more about the degree and the speed at which things can keep improving. At least, if you are trying to figure out how to make money trading, that's the best question.

Posted by
Accrued Interest

7 comments:

Hi Al,Great post as usual. Regards equities, I believe the stock market has gone too far too fast. Wall Street tends to be ahead of the broader economy by a couple of quarters but I do not see a major recovery anytime before 2011. There are still some really huge issues out there, some of which you touched on. The banking sector is really very weak and it is probably the last place I would want to invest money right now.

In the near to intermediate term I remain concerned that we are witnessing a bear market rally. It certainly shows all of the classic signs. But even if we don't have another major crash (I think the odds are well below 50%) and retest the March lows, I do think a sharp correction is coming.

Anyone with significant equity exposure who is up 30%+ since March might want to seriously consider taking some profit (a poor term given how much most people lost last year) and spread that around in some more conservative investments.

On a side note how do you feel about diversifying bond holdings to include some foreign securities as a hedge against dollar decline or possible inflation? (I know you are skeptical about inflation.)

I can't wait to see all the derivatives, underwater mortgages, and every other piece of trash on the banks balance sheets to be valued for what it's worth - zero. That will bankrupt many banks and send them tumbling.

I could not disagree with you more.The shadow inventory will be a drag on the housing market and will continue to exude pressure on prices for a long long time.Second,the high end of the real estate market and the jumbo loan holders who's default rate has been increasing unabated will create enormous headwind.Mortgage rates are at historic low's and if the early 80'd taught us anything,its that when not if the rates start moving higher then prices will inevitably move lower.I think what we are witnessing is nothing more than s head fake and just like the stock market,nothing goes up or down in a straight line.

Not sure why you think new home sales are increasing. Look at calculated risk's table of non-seasonally adjusted home sales--June is still way down from last year, even with the $8000 credit and low rates. The headline just as easily could have been "new home sales in June worst since 1982." I will admit that the trend looks better than earlier this year, but let's not kid ourselves.

Please read my link by clicking my name. FASB is coming back! And this will hurt the banks badly and cause investors and consumers to lose BIG TIME. Please pass this knowledge along as I know the blogger here speaks a lot about M2M

John (Ad Orientem), I think that equities will continue rising so long as the Chinese keep printing money (aka forced lending). There are major problems with the disclosure of their GDP calculations and other macro data.

For ex, some traders believe that Chinese M2 increased 29% in June alone. ALONE. Can you say bubblicious?

The problem is that since their society is more closed than a GS firewall, we won't know when the inevitable bursting occurs.

I agree with a lot of your assessment, but I think you're too sanguine about housing. No discussion about housing is complete without considering the "mix". Sales rates are up because large numbers of distressed low priced homes are being sold. I think the middle and high end of the markets (where borrowers typically have more ability to avoid foreclosure in the short term) is the next shoe to drop. It won't drop as hard or fast as Vegas or the Inland Empire, but I think the supply/demand dynamics will be terrible for the next decade. Any slight rise in prices will bring a wave of sellers that can breakeven at that price.

Another consideration is that a lot of recent low end buyers have been cash-based investors (i.e. they can rent the property at cash flow breakeven). In most areas that I know well (LA, NY, and SF), the high end is nowhere near breakeven for a landlord.

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.